In May, KKR’s co-head of Americas private equity, Pete Stavros, had some news for staff at CHI Overhead Doors: on the headquarters’ factory floor, Stavros informed them that their pay-outs from an employee ownership programme they had joined seven years prior would range from 1.5 to 6.5 times their individual annual salaries.
Among those gathered to celebrate was factory worker Josh Ryan, who said in a video capturing KKR’s presentation that he didn’t expect to wake up that Wednesday to find out that “everything you’ve ever wanted to do in your life you could do now, all because you worked and did things the right way, and someone held up their word to you”.
CHI – a 41-year-old, Illinois-based garage door manufacturer – has been heralded as a success story for the concept of equity grants for all employees, ranging in this case from truck drivers and factory workers to those who worked in the corporate office.
KKR sold CHI in May to steel company Nucor for $3 billion, garnering a 10x multiple on its original investment. The deal is significant for all 800 CHI employees, who will collectively receive a pay-out of $360 million. All hourly employees received between $20,000 and $800,000 before taxes when the deal was completed in June.
In KKR’s CHI investment, employees’ equity comes out of the management equity plan, Stavros tells Private Equity International. He notes that, in standard transactions, PE firms typically give away a portion of equity – between 10 and 15 percent, usually in the form of options – and mainly allocate that to the senior management
team (see first table).
“In a programme like [CHI’s], a portion is simply allocated to non-management employees. To accommodate the inclusion of all employees in the company, the people at the very top get slightly less and the programme is probably just a tiny bit bigger.”
A company that, for example, has a 12 percent management equity plan could see that plan go down 1 percentage point to 11 percent for senior management, while the rest of the workforce shares 3 percent. This means 14 percent of the total equity of the company is distributed across the entire employee base, as opposed to 12 percent across senior
Doing this dilutes all existing shareholders’ stakes on a pro rata basis. That is, everyone – including the LP and GP, by virtue of the fund and the senior management— gets a slightly smaller piece of the pie.
Stavros says that in most businesses, giving away an extra 2 percent of the company’s equity to employees, combined with reducing the share given to senior management by 1 percentage point, is usually enough to bring all other employees into the company’s ownership culture, while also giving them a chance to build their own wealth.
While the arguments in favour of the employee ownership model – increased performance, employee retention and a fairer distribution of wealth – are generally accepted as logical, how does distributing an inherently finite resource like equity among a wider base of people affect ultimate fund returns for LPs? And, as a consequence of the fund holding less equity than it otherwise would, will it receive less upside upon exit?
Employee ownership in action
KKR is a leader in the proliferation of employee ownership programmes. We take a look at some of its most successful ventures so far
Minnesota Rubber and Plastics (2018-22)
KKR introduced broad-based ownership across MRP’s entire employee base – 1,300 non-management staff across six countries and four states – when it bought the company in November 2018. During KKR’s ownership, MRP has seen significant improvements in safety, waste reduction and the speed of new product delivery. EBITDA margins grew from 21 percent to 25 percent, and KKR expects the sale to Trelleborg Group to deliver a 3x multiple of its cost after approximately 3.5 years, Craig Larson, head of investor relations at KKR, said on the firm’s Q2 2022 results call.
On average, employees will receive 100 percent of their annual income and equity pay-outs from the sale, with the more tenured employees receiving 200 percent of their annual income, he added. The transaction, which is valued at approximately $950 million, is expected to close by year-end.
CHI Overhead Doors (2015-22)
According to CHI Overhead Doors, its EBITDA margin grew from 21 percent to more than 30 percent during KKR’s ownership. Revenue grew by nearly 120 percent organically, enabled by investments in its existing manufacturing facility in Illinois and the construction of a second plant in Indiana. Operating improvements covered nearly all aspects of the business, ranging from procurement and scrap reduction to labour productivity and net working capital optimisation.
Ingersoll Rand (2013-21)
KKR’s North America Fund XI took a majority stake in industrial manufacturing business Ingersoll Rand, formerly known as Gardner Denver, in 2013.
In September 2020, 16,000 employees, excluding management, were granted stock options worth a combined $150 million. This was the second grant during KKR’s ownership of the 150-year-old manufacturing business; at the time of the 2017 Gardner Denver initial public offering, all employees had participated in a $100 million grant. KKR made a profit of roughly $4 billion from its eight-year investment in the company.
Throughout KKR’s ownership, the quit rate at Ingersoll Rand dropped to 3 percent per year, down from 20 percent. The company saw a 71 percent decrease in safety incidents and enterprise value increased from roughly $3 billion in 2013 to $21 billion on exit.
Work in progress
When it comes to public companies, there is evidence that employee ownership can lead to better corporate performance. Over the last 15 years, shares in employee-owned businesses in the UK, such as retailer John Lewis and design and engineering company Arup Group, have outperformed those in the FTSE All-Share Index, according to the UK Employee Ownership Index, which measures listed companies with more than 10 percent ownership by ordinary employees.
Employee-owned companies also protected their workers’ jobs at a rate four times higher than that of traditionally owned companies during the pandemic, according to a report by the Institute for the Study of Employee Ownership and Profit Sharing at Rutgers School of Management and Labor Relations. Studies from research firm Gallup also point to the correlation between employee engagement and performance.
When it comes to privately owned companies, however, there’s little evidence of how corporate performance is affected. PEI spoke to several academics who focus on finance and private equity for this report; all of them noted the area has not been well researched, being too recent for anything systematic, especially in private equity-backed companies.
“[These programmes cost] money, but people may be working harder,” says Ludovic Phalippou, a professor of financial economics at the University of Oxford’s Saïd Business School. “So [it’s] unclear what [the] net effect is.”
John Gilligan, director of the Oxford Saïd Finance Lab, notes that while employee ownership at PE-owned companies is not a well-researched topic, it is also not a particularly new one. “The general view has always tended towards putting equity in the hands of those who control the levers of strategy – and taking it away from them if they leave – as they can make the biggest impact on performance and are best motivated by exaggerated capital gains from leverage. At the more junior level, bonuses are much simpler to operate and can be designed to be more closely aligned with employee needs.”
Gilligan says there is no reason why the conclusions drawn from studies involving public companies can’t be applied to privately held ones. “If we believe that equity incentives operate by encouraging entrepreneurial activity, there is no reason on Earth why that would stop at the boardroom. They don’t [stop at the boardroom] in Silicon Valley.” Steven Kaplan, an expert on private equity at the University of Chicago Booth and co-creator of the Kaplan-Schoar Public Market Equivalent, says: “LPs’ primary goal is returns. So, if employee ownership helps returns, that is obviously positive. Some LPs also care about ESG. For some, employee ownership is a positive on the S. So, holding returns equal, employee ownership is also a positive for LPs.”
PODCAST: What does employee ownership mean for investors’ returns?
PEI senior editor Adam Le and senior reporter Carmela Mendoza discuss how private equity firms sharing equity with an entire workforce can create upside and value for investors.
Narrowing the wealth gap
The notion of employee ownership has been gathering steam in the private equity industry. April saw the launch of Ownership Works, a non-profit that aims to create $20 billion of wealth generation through employee ownership over the next decade. The effort, which was founded by KKR’s Stavros, is a collaboration between 60 organisations, including Apollo Global Management, TPG and some of the US’s biggest private equity LPs, such as the California Public Employees’ Retirement System and the Washington State Investment Board. The private equity firms involved have pledged to institute employee ownership at a minimum of three portfolio companies by the end of 2023.
This is how the theory of employee ownership goes: the company provides every employee with the opportunity to become a part owner, resulting in them becoming stakeholders in the company’s success and having some control rights and voting rights in the way the business is run.
There is no one-size-fits-all approach to this theory, and employees can achieve broad-based ownership in a variety of ways. An example is through employee stock ownership plans (ESOP), which gained traction in the 1980s amid a surge in leveraged buyouts and mergers and acquisitions.
ESOPs are a defined contribution benefit plan in the US, commonly financed with loans or existing funds. Employees can become owners by buying the company’s shares directly or being given stock by the company. When a worker’s employment ends, the company can make an ESOP distribution in the form of shares, cash or a combination of both.
Kelso, a North America-focused, mid-market PE firm, has operated on this model for more than 40 years. Its founder, Louis Kelso, designed the first tax-qualified plan as a tool for business succession. He created the first ESOP in 1956 as a way to transition ownership of one of its client firms, Peninsula Newspapers, from its founders to employees. Nearly two decades later, the Employee Retirement Income Security Act of 1974 wrote the ESOP into the Internal Revenue Code for the first time.
Phil Berney, co-chief executive of Kelso, notes that the firm was initially an ESOP consulting business before it became a private equity firm. “We moved in the 1980s from using ESOPs to using the philosophy of ESOPs – of putting stock deeper in the organisation in many employees’ hands so they can participate in the upside of being an owner in the business. That model is enhanced by sharing profits on top of that.”
Kelso’s co-chief executive, Frank Loverro, adds: “At the end of the day, what we’re trying to do is to drive good equity performance, which will benefit everyone.”
There are approximately 6,482 ESOPs in the US, which cover nearly 14 million participants and hold total assets of over $1.6 trillion, according to figures from the Department of Labor for 2019, the most recent year for which data is available.
Home run for all
Investing in the workforce was both a morale boost and a safety benefit for KKR portfolio company CHI Overheard Doors
When Dave Bangert, chief executive of CHI Overhead Doors, asked employees in 2017 how to re-invest $1 million from its employee ownership programme back into the business in order to improve their day-to-day experience, air conditioning got the unanimous vote.
CHI’s manufacturing plant in Arthur, central Illinois, would heat up to sweltering temperatures in the summer: in the height of the busy season in July and August, temperatures could soar through the 30s in the plant and close to 40 degrees Celsius in other areas of the factory building. Air conditioning, which was initially deemed unfeasible due to the plant’s size, helped bring the temperature down when it was installed in 2018.
“That was a home run for everybody,” Bangert tells Private Equity International. “And then we moved to add break rooms, a cafeteria with healthier food options and an on-site health clinic.” CHI had sought input from its employees through its first employee survey in 2017 as part of its employee ownership programme, instigated by owner KKR, in which all employees were given a say in how to improve the work environment.
“The process of getting everyone’s input and thinking about how we can create a great work environment was particularly rewarding,” he adds.
Is performance better?
Of all KKR’s North America funds, the ones that have implemented broad-based employee ownership and alignment programmes – across more than 25 companies since 2011 – show healthy returns. The firm’s 2017-vintage, $13.9 billion Americas fund delivered a 26.3 percent net rate of return and a 2x gross multiple as of 30 June 2022. Its predecessor – the 2012-vintage North America Fund XI – had returned 20.2 percent and a 2.7x multiple as of the same period, according to US regulatory filings.
KKR’s largest private equity vehicle – the $19 billion North America XIII, which held its final close this year – will implement employee ownership at all majority-owned companies. The firm also plans to roll out the programme in other markets.
In Kelso’s case, Berney says the firm believes it gets “premium performance and more equitable performance by adhering to the strategy”. While there is no way to test it, time has proven that it works, he adds.
Kelso’s 2014-vintage, $2.6 billion Fund IX delivered a 20.7 percent net internal rate of return as of 31 March, according to documents from the Maine Public Employees Retirement System. Fund X, a 2018-vintage, $2.5 billion vehicle, generated 47.1 percent as of the same period. Cambridge Associates data shows US PE funds in vintage years 2014 and 2018 delivered net fund-level performance of 22.8 percent and 26.6 percent, respectively, as of end-June 2021.
Leonard Green & Partners, a member of Ownership Works, is another PE firm that implements broad-based equity ownership. The returns for investments with such programmes tend to exceed those without, John Danhakl, a managing partner at the firm, said during a panel on employee ownership at the Milken Institute Global Conference in May. Ten companies that his firm owns, all of which have rolled out broad-based equity ownership, have delivered multiples on invested capital of more than 4x for their investors, according to Danhakl.
“It helps us do our job better,” Danhakl said on the panel.
According to KKR’s Stavros, there isn’t a simple or single answer to the question of how an investment that uses the employee ownership model will impact returns at the fund level.
“I do not for a second agree that you’re losing an ounce of financial return,” Stavros says. “This is better. We just made 10 times our money on a garage door company. I don’t know what better case study [there is]. This is not some high-flying software business – it’s a garage door company whose profit margins went from 20 percent to 35 percent.”
He gives an example of how employee ownership can affect returns: take company A with $1 billion of revenue and $200 million of EBITDA, in which EBITDA is projected to grow at 9.5 percent CAGR to $315 million after five years (see second table) and which has an employee equity programme. With 14 percent of equity spread across all employees, LPs will see performance of 2.87x gross MOIC and a 23.5 gross internal rate of return. This compares with a 2.76 gross MOIC and 22.5 percent gross IRR in a deal in which the standard 12 percent of equity is shared with senior management only.
In this example, a 1 percent increase in EBITDA at the end of a five-year investment period is all that’s required in order for the programme to pay for itself.
Stavros also points out it isn’t enough to simply share ownership. These programmes take a lot of time, effort and resources to be effective. “How well the programmes are structured, communicated and implemented matters. And from an employee engagement perspective, the business plan… and the company’s financial information [need] to be shared transparently.”
Other private equity funds with experience of employee ownership and broad profit sharing include Ardian and Partners Group
In 2008, Ardian – then AXA Private Equity – made its first distribution to portfolio company employees when it sold Photonis, a designer and manufacturer of electro‑optical components, to Astorg Partners. Ardian bought back the company from Astorg in 2011 and fully exited the investment in 2021.
It is unclear how much exactly Ardian paid the employees of Photonis as part of its profit-sharing scheme. The firm says it has paid bonuses to more than 28,000 employees at 37 portfolio companies over the last 14 years, with proceeds representing between one- and six-months’ salary for each employee, according to its 2021 Sustainability Report.
Ardian has rolled out incentive schemes or employee shareholding schemes in more than 80 percent of the companies in its buyout, expansion and infrastructure portfolios as of 2021. Candice Brenet, head of sustainability and digital transformation at Ardian, says the firm believes that “people are the engine for growth and they should be rewarded for their contribution to the company – not only top managers, but all employees.
“That was the rationale within Ardian for establishing annual profit-sharing plans… Not only do we see profit sharing as a fair way to drive our business – it has also proved to be a strong buy-in factor for nurturing employee engagement, which is a challenge for many large organisations. Therefore, it is natural for us to partner with management teams who share this view that success is collective.”
Partners Group, meanwhile, recently extended equity ownership to employees of portfolio companies. As part of its pilot Stakeholder Benefits Programme introduced in March 2020, the firm established an employee incentive programme at German toymaker Schleich, according to its latest corporate sustainability report. The initiative aims to “reinvest substantially” in portfolio company employees’ development, wellbeing and financial situations. The firm plans to roll out the programme across the rest of the portfolio over the coming years.
What do LPs – from which the bulk of the additional equity given to employees in these ownership programmes comes – make of these programmes?
PEI contacted 15 institutional investors to ask for their views on employee ownership within private equity-backed companies. Specifically, we asked about their understanding of the employee ownership model, how such programmes affect fund returns, where equity shared with the employees comes from, and whether they think the model is positive for the industry. Of the LPs that responded, the majority said they did not understand how the model affected fund returns, yet all generally noted that spreading a bit of the wealth is a good thing. One-third of the LPs were investors in KKR’s North America funds.
A key part of how KKR’s programme appears to work for LPs is its inbuilt hedge in the form of equity options. Crucially, the fund and senior management’s equity is only diluted if the company meets its growth targets.
“We do [employee equity programmes] with very large option plans – so much larger than a typical private equity firm would do,” Stavros said in a video for KKR’s 2018 investor day. “It is important that we use options because we obviously only want our investors getting diluted to the extent there is real performance.”
While this type of structure isn’t new, it’s important to highlight that the options scheme still needs protection against refinancing, as well as any dilution in acquisitions paid for with a mix of debt and equity, says Gilligan from the Oxford Saïd Finance Lab.
With equity options, employees only share in the upside if the company hits its growth targets. Similarly, LPs will only have their equity diluted if the company performs – which means greater profits overall, even though their equity holdings are slightly smaller.
A step in the right direction
For several of the LPs we spoke to, the question of how on a mathematical level the dilution of their shares would affect fund returns seemed a second-order point of importance.
“The model, for the longest time, has been about maximising shareholder value versus stakeholder value,” says an investment director at a US public pension that has about $1 billion in PE exposure.
“If [broad-based employee ownership is] the way of the future, I am for it. And it should be a requirement for fund managers.”
The investment director adds: “If we were doing a fund manager search and it came down to one firm that [applies an employee ownership scheme] versus another that didn’t, I would be more inclined to award a commitment to the one that did, even if it means less returns. You can make up for that in other ways – for example, by not paying up when you go in. And if firms are also achieving their target returns while producing socially driven KPIs, that’s great.”
A senior investment officer at a UK-based foundation that has invested in funds managed by Carlyle Group and Silver Lake also voices his support for employee ownership, largely because of its social value, and says that he would like to see private equity be part of the solution to labour inequality.
He adds that doing the right thing usually leads to long-term value.
“We’re not interested in one-year returns – we’re interested in five- or 10-year returns,” the senior investment officer says. “Creating a good culture and a good business is probably more important than stripping every last dollar of value.”
The view from several GPs PEI spoke to for this report is similar: we know it works, but we don’t know by how much – and that’s OK.
“You can’t measure the intangibles of morale, extra productivity and how that leads to extra IRR benefit,” says a senior executive from a global buyout firm, who is also among the founding partners of Ownership Works. “It is hard to measure, but the net benefit is high.”
“It’s very hard to know, but you can probably measure it in a company culturally,” adds a London-based head of PE at a global investment firm. “That is, how do employees talk about the business? Is there a sense of pride?”
Some LPs we spoke to weren’t as convinced as others about whether the model creates additional value for investors, though they were in the minority.
“When I read the latest news about employee ownership, part of me thought, ‘So what?’” says Sam Robinson, managing partner at Singapore-based North-East Family Office. “There’s nearly always an employee stock option plan in private equity. Even in mid-market Asia, I would estimate something like 75 percent of deals will have employee ownership schemes. It’s always been there.
“That said, if people are putting more into ESOPs, then I’d be a bit more worried about my net return – there could be a tipping point where you’re giving away too much of your equity stake.”
Some industry observers were initially sceptical of the employee ownership programmes implemented by private equity firms. James Bonham, president of the Washington, DC-based Employee Stock Ownership Plan Association, described Ownership Works in a members-only publication in May as a “cheap way to diffuse heat” from the negative public sentiment private equity has encountered in recent years. Bonham tells PEI that his article, which was originally written for a specific audience and not the broader public, catalysed constructive conversation with the leadership of Ownership Works. He also backtracked on his criticism and says he believes Stavros is “genuinely trying to find new and innovative ways to include employees in equity growth, and his ambition is to create a more financially equitable and inclusive economy. I support and applaud that effort”.
He adds that he is “learning more about [the Ownership Works] model”, and that, in turn, Ownership Works is “learning more about the concerns and experiences that the ESOP community has had with private equity”. Bonham also notes that PE firms must have appropriate transparency and accountability to the employees throughout the process, and “they have true ownership that is not reversible once it has been awarded”.
Some LPs clearly think this is the right way forward for an industry that still has to convince certain corners of society that it’s not involved in asset stripping and mass redundancies when it buys and sells companies. One KKR investor described the firm as being “at the forefront of industry improvements, which are crucial to creating value and staying on the right side of history”.
Allyson Tucker, chief executive of Washington State’s $152 billion pension fund, which is also an investor in KKR’s North America funds, says that the employee ownership model will benefit both management and workers in a way that will yield strong long-term returns for investors.
That said, Tucker notes that it’s too soon to know with certainty what the qualitative and quantitative outcomes will be. “We will evaluate this question as the programme gains acceptance and momentum.”
Adam Le, Helen de Beer and Alex Lynn contributed to this report.
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